Assessing Creditworthiness of a Corporate Customer A Field Perspective

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Authors: Rajiv Fernando
Faculty Associate,
ICMR (IBS Center for Management Research).

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Credit Risk Models and Ratings

With the changing business environment and emergence of the global economy, the risks associated with lending have increased manifold. However, of the many risks, the most fundamental of all is the credit risk. Credit risk is the risk or uncertainty of the counterparty's inability to meet its obligations. This essentially is a factor of:

a) Default risk: The probability of the client defaulting on their obligation.
b) Exposure Risk: The amount of loan that is outstanding at the time of default.
c) Recovery Risk: The extent to which the outstanding loan can be recovered from the collateral and other securities.

In order to study risk and build risk mitigation models, banks generally have a separate team of credit analysts in the risk management department. Developing credit-scoring models is a highly systematic and formulaic activity that uses many historical data.

There are models like Merton model, KMV model etc., that are used by analysts to quantify, aggregate and manage all types of risks across geographies, industrial sectors, business entities and product lines. The expected default losses and unexpected losses are also quantified by these models.

Based on these models, credit analysts prepare credit ratings for the banks internal use. There are also firms like Standard & Poor's (S&P), Moody's, CRISIL (recently S&P had placed a bid of INR 2.4 billion to become the majority stakeholder) which develop credit ratings that are used by investors to judge the credit quality of the debt instrument or a particular company. An indication of the system of credit ratings employed by Standard & Poor's applied to bonds is given in Exhibit I.

As per the RBI guidelines, banks are supposed to link the pricing of their products to the credit rating of the entity. Hence, an AAA-rated entity would get a finer pricing as compared to an AA-rated entity, because the credit risk charge would be lower for the former. Hence, a banker will have to collect information from the client so as to arrive at the creditworthiness in the form of a credit rating for the company or entity. Also under the Basel II norms, risk profiling of borrowers would become necessary, as banks would have to allocate capital depending on the credit rating of the borrower.

Exhibit I: Standard & Poor's Credit Ratings

Credit Rating	Description
AAA	Best credit quality-Extremely reliable with regard to financial obligations
AA	Very good credit quality-Very reliable.
A	More susceptible to economic conditions-still good credit quality.
BBB	Lowest rating in investment grade
BB	Caution is necessary-Best sub-investment credit quality
B	Vulnerable to changes in economic conditions-Currently showing the ability to meet its financial obligations
CCC	Currently vulnerable to nonpayment-Dependent on favorable economic conditions
CC	Highly vulnerable to a payment default
C	Close to or already bankrupt-payment on the obligation currently continued.
D	Payment default on some financial obligation has actually occurred.
Note: Ratings are also modified with + or - signs, so an AA- is a higher rating than is an A+ rating. With such modifications, BBB- is the lowest investment grade rating.

Source: Standard & Poor's

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